Investors often overlook SEC filings, and it is the job of the 10Q Detective to dig through businesses’ 8-K and 10-Q SEC filings, looking for financial statement ‘soft spots,'(depreciation policies, warranty reserves, and restructuring charges, etc.)that may materially impact Quality of Earnings.

Wednesday, January 16, 2008

The common approach to monitoring related-party transactions has been (i) disclosure of potential conflicts of interest in regulatory filings and (ii) financial governance by ‘independent’ directors on the board, representing the outside shareholder interests. Nonetheless, despite the intended transparency, these ‘best practice’ principles do little to stop insiders from enriching themselves at the expense of ordinary stockholders.

Charles Liang and his spouse, Chiu-Chu (Sara) Liu Liang, who co-founded Super Micro Computer (SMCI-$8.60), and are currently the Chief Executive Office/ Chairman of the Board and Vice President of Operations/Treasurer, respectively, of this provider of high-performance servers and workstation solutions, continue to financially enrich themselves and their families through stakes in related-party transactions, according to a proxy statement filed last week with the Securities and Exchange Commission.

Transactions with Ablecom Technology Inc.

Charles Liang and his wife jointly own approximately 30.7% of Ablecom, a Taiwan-based contract manufacturer that provides product design, outsource manufacturing, and distribution services for SMCI.

In addition, Yih-Shyan (Wally) Liaw, Vice President of International Sales and a third founder of SMCI, and Mr. Charles Liang, Ms. Liang, Mr. Steve Liang, and relatives of these individuals own more than 80% of Ablecom's outstanding common stock.

Ablecom’s net sales to SMCI and its net sales of SMCI products to others comprise a substantial majority of Ablecom’s net sales. SMCI purchased products from Ablecom totaling approximately $95.67 million, which represented about 34% of cost of sales; products sold to Ablecom (for distribution in Taiwan) totaling approximately $7.32 million for the fiscal year ended June 30, 2007.

SMCI intends to increase its business operations in Asia, currently about 14.3% of net sales. In an effort to reduce product costs, the Company plans to expand its warehousing capacity and its manufacturing relationship with Ablecom in China, according to management. This increasing reliance on Ablecom as a limited-source supplier, however, could subject the Company to disruptions in supply, compromising the Company’s ability to satisfy customer orders on a timely basis.

The 10Q Detective is suspect of this ‘cost containment’ defense, for pursuant to contract terms, Ablecom is the exclusive manufacturer of many chassis and power supply products sold to SMCI! In addition, business dealings with Ablecom are not arms-length agreements—which means the commercial terms of these agreements may be less favorable than contracts that might be obtained in negotiations with unrelated third parties.

For the 1Q:08 ended September 30, 2007, cost of sales increased 40 basis points to 80.5% of net sales, driven by an increase in sales of more mature products (which have a decrease in average selling prices).

Corporate Governance

The 10Q Detective is raising a red flag, too, regarding independent director composition. Although the board is controlled by a slight majority of independent outsiders (four out of seven), the founders—Charles Liang, Sara Liu Liang, and Yih-Shyan (Wally) Liaw—collectively control 41.7% of the common stock outstanding, which raises additional questions about the oversight effectiveness of the outside directors in place at SMCI.

There is nothing more corrupting, nothing more destructive of the noblest and finest feelings of our nature, than the exercise of unlimited power. ~ President William Henry Harrison (1773 – 1841)

New signings with Ablecom suggest that the independent directors might not be serving their intended purpose in aligning the interests of management with those of common stockholders.

Investment Considerations

The computer server market is highly competitive, with the Company squaring off against hardware giants like Dell, Hewlett-Packard, and IBM, as well as original design manufacturers like Rackable Systems and Quanta Computer.

In business since 1993, Super Micro Computer went public at $8.00 a share (March 29, 2007), hitting a 52-week high of $11.85 (June 5, 2007). Recent price weakness, however, reflects investor skittishness with the overall softness in the market for core server sales.

Cautionary economic indicators and signals that competitors continue to lower forward revenue guidance would suggest—that short of take-over rumors—few catalysts exist for a recovery in SMCI’s share price.

Editor David J. Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

2 comments:

Anonymous
said...

David,You've highlighted an interesting conflict of interest here -- this clearly looks like a case of inside dealing. It will be interesting to see if the investing public picks up this. Otherwise, investors could get hurt by this company's enrichment of its insiders.Thanks for doing the hard work!

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Prior to founding the 10Q Detective, I held equity analyst positions with three brokerage firms and published the investment newsletter e-Growth Profit Letter - dedicated to uncovering companies with innovative, proprietary technologies in a range of industries. My work has been published in The Dick Davis Digest, The Bull & Bear Financial Report, BusinessWeek, CBS Interactive, Forbes, Kiplingers Personal Finance, MSN Money, TheStreet.com, 24/7 Wall Street, The Wall St. Journal, The International Herald Tribune, and Investors Business Daily.
The 10Q Detective is recommended as a 'Must-Read' money blog in Kiplingers (Oct. 2006 & May 2008), Washington Post (May 2009); a 'Best of Financial Blog' by BusinessWeek (Feb. 2007 & April 2008),a 'Smart Stop' by The Journal of Accountancy (March 2008); 'Top 25' by Time magazine, a 'Top 50 Money Blog' by CurrencyTrading.net (April 2008); and, a 2011 LexisNexis Business Law Blog Nominee.